Rite Aid’s total debt for fiscal year 2009 is $6,370,899,000. This is made up of
$51,502,000 in current maturities of long-term debt, $6,166,706,000 in long-term debt, and $152,691,000 in lease financing obligations. This may seem like an
excessive amount of debt. This is true, and Rite Aid is not in a good position.
However, more on this analysis will come later. For now, a few of the different types of Rite Aid’s loans and their relating journal entries will be illustrated.
The first major type of debt to discuss is a 7.5% senior secured note due March 2017. From the key terms explanation above, it is clear that this note is one that is backed by the company’s collateral, and is high on the repayment priority list.
The 7.5% denotes the rate of interest that must be paid in return for borrowing this money each year. This note has a face value of $500,000. It was sold at par, as its carrying value does not change from FY2008 to FY2009. Below is the journal entry to record the issuance of this note.
Cash 500,000
Notes Payable 500,000
This note is sold at par value, as there is no premium or discount recorded, and no discrepancy between cash received and the face value of the note. Now, because the majority of long-term debts include semi-annual interest payments, the following entries must be done twice a year to record payments of interest.
Interest Expense 37,500
Cash 37,500
Here, the $37,500 expense comes from the face value of the note times the coupon rate multiplied by the fraction of the year that the interest expense is covering, or $500,000 * 7.5% * 6/12. These semiannual payments will occur until the time of maturity, or March 2017. Upon retiring the note, the following journal entry would be required.
Notes Payable 500,000
Cash 500,000
Note: There may also be an entry for accrued interest from January 2017 to March 2017.
The next type of note is a guaranteed unsecured note with a coupon rate of 9.375% and a face value of $410,000. This note is sold at a discount, meaning its coupon rate is lower than its effective yield. The current carrying value of this note is $405,951, meaning the current unamortized discount makes up the difference, or
$4,049. This is important when it comes to recording interest expense. Because the discount has to be amortized over the life of the note to bring it to face value at maturity, it is reduced during every interest payment. Essentially, it raises interest expense above the actual cash payment in order to account for the fact that the note was bought at a discounted price from face value. The entry to do so is shown below:
Interest Expense 39,143
Cash 38,438
Discount on NP 705
The $38,438 cash payment is calculated by multiplying the face value by the stated interest rate ($410,000 * 9.375%). The discount on NP is found by calculating the difference between the unamortized discount from FY2008 to that of FY2009 ($4,754 - $4,049). Thus, combining those two makes up the total interest expense for the period. Using the rate function of excel, we find that the effective interest rate for this note is 9.66%.
The next note under analysis is a 9.75% senior secured note also with a face value of $410,000, due June 2016. This note, like the previous one, was sold at a
discount. In accounting terms, it was sold at 98.2, or 98.2% of the face value. The journal entry to record this transaction is as follows:
Cash 402,620
Discount on NP 7,380 NP
410,000
Using the rate function of excel, we then find that this note has an effective yield of 10.1%. We use this information to create an amortization table to show the schedule and amounts of interest expense and the cash payments and discount amortizations that make them up.
Figure 8-1 Effective Interest Rate
Date Interest
Payment Interest
Expense Bond Discount
Amortization Net Book Value of Debt
Effective Interest
Rate 6/30/09 $ - $ - $ - $402,620 10.12%
6/30/10 39,975 40,750 775 403,395
6/30/11 39,975 40,828 853 404,248
6/30/12 39,975 40,915 940 405,188
6/30/13 39,975 41,010 1,035 406,223
6/30/14 39,975 41,115 1,140 407,363
6/30/15 39,975 41,230 1,255 408,618
6/30/16 $39,975 $41,357 $1,382 $410,000
The table above shows the amortization process of bringing the note to face value, so when it is paid off at maturity, there will be no discrepancy on the books.
To give an example of how this table translates into journal entries for a given interest payment, the following entry for February 27, 2010 is shown below:
Interest Expense 27,167
Discount on BP 517
Interest Payable 26,650
The discrepancy between this interest expense and the one listed on the table for 6/30/2010 is due to this being an accrual of interest at fiscal year end. In
other words, the interest owed at the end of February is $27,167, but when the actual payment comes due in June, four more months will have passed, and the total amount of interest expense will be $40,750, as shown on the table. Also on February 27, 2010, the carrying value of the note would be equal to the original cash purchase price plus the amortized discount, or $402,620 + $517, which gives us $403,137.
Sometimes, companies use a different method to amortize the discount on a note payable. This second method is called straight-line amortization, which essentially involves amortizing it equally over all periods, rather than using an effective interest method shown above. The following table illustrates this straight- line method.
Figure 8-2
Straight Line Amortization
Date Interest
Payment Interest
Expense Bond Discount
Amortization Net Book Value of Debt
Effective Interest
Rate 6/30/09 $ - $ - $ - $402,620
6/30/10 39,975 41,029 1,054 403,674 10.19%
6/30/11 39,975 41,029 1,054 404,729 10.16%
6/30/12 39,975 41,029 1,054 405,783 10.14%
6/30/13 39,975 41,029 1,054 406,837 10.11%
6/30/14 39,975 41,029 1,054 407,891 10.08%
6/30/15 39,975 41,029 1,054 408,946 10.06%
6/30/16 $39,975 $41,029 $1,054 $410,000 10.03%
With this method, all interest payment, interest expenses, and discount amortizations are identical for every period. This seems like a fair way to record these transactions. However, doing so involves using varying effective interest rates, as shown in the Effective Interest Rate column. Thus, it is generally preferred that companies use the effective interest rate method, though if not materially different,
it is acceptable to use the straight-line method. To understand the differences in the two methods, refer to figure 8-3:
Figure 8-3
Interest Expense Comparison
Date Straight Line Effective Interest Difference 6/30/09 $ - $ - $ -
6/30/10 41,029 40,750 279
6/30/11 41,029 40,828 201
6/30/12 41,029 40,915 114
6/30/13 41,029 41,010 19
6/30/14 41,029 41,115 -85
6/30/15 41,029 41,230 -201
6/30/16 $41,029 $41,357 -$328
In this example, the largest difference between the two methods results in a mere $328 discrepancy, which is not materially different. Therefore either method is acceptable in this case. However, in other cases, typically involving notes with longer terms to maturity, the differences can be substantial. In situations where this is the case, the effective interest method must be used.